What’s the chance inflation remains elevated, for at least the next couple of years?

I know inflation erodes the value of savings, but oddly enough, for a prosperous society, a little bit of inflation is often required to stimulate innovation and investment. To illustrate:

• Higher input costs can be the catalyst for a business, to innovate and invest, to improve productivity and reduce costs,
• While higher prices (for the goods and services a business sells) can be the catalyst for a business to innovate and invest, to increase output, create more jobs and meet the needs of more customers.

A little bit of inflation is certainly better than stagnation and deflation. When there’s stagnation and deflation there is waste, lifestyles and living standards are falling, and there is a heavy price to be paid by future generations.  

While when inflation is too high, it destroys (devalues) savings and with fewer savings there is less investment. With less investment, there are fewer jobs and prices continue to rise

There are two types of inflation, supply side and demand side:

• Supply side is often associated with a ‘shock’, e.g. a cyclone wiping out a banana crop and prices are rising due to limited supply but it can also come from a lack of investment e.g. in housing.
• Demand side is where there’s NO shortage of supply but consumers are willing and able to pay more and do.

Arguably, the inflation caused by Covid lock downs in 2020, was akin to a supply side shock and arguably it was possible for inflation to return to pre-covid levels. But, when rolling lockdowns were extended from weeks to years, sustained by taxpayer funded Government handouts and then you add the cost of sanctions on Russian food, energy and timber, and a shock has become a 3½ year trend. The question as to whether we have ‘demand side inflation’, which has become entrenched in a ‘wage-price-spiral’, is still being debated. But there are a couple of themes that are worth considering:

1. We are creatures of habit and if we enjoy what we are doing we are likely to keep doing it, even if it means we have to ask for a pay rise or change jobs.
   
   To illustrate, if you borrowed to buy a house at a 3% interest rate and you could pay off the loan with 20% of your income over 20 years, assuming 2% p.a. wages growth, when interest rates go to 7%, you are likely to ask for a pay rise. Yes, you may have to increase your repayments from 20% of your income to 25% of your income but if wages growth goes from 2% p.a. to 4.5% p.a. you will still be able to pay-off the loan in 20 years.
   
   What’s more, if you can change jobs and get a promotion or two, call it 10% p.a. wages growth, then you will be able to keep your repayments to less than 20% of your income and pay off the loan in under 20 years, with no change to your lifestyle or living standard.
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2. Currently, there is very little spare capacity in Australia’s jobs market. Unemployment and underemployment* are at record low levels, while work force participation is at record high levels and in many industries, there are more vacancies, than there are people looking for work. What’s more, it is a similar story in the USA, Europe, Japan and most other OECD countries. So where is the additional skilled labour going to come from? Arguably Australia needs higher wages just to retain, let alone attract additional, skilled workers. ^{(*Under employment is where you have a part time job but would like more hours or even a full-time job.)}
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3. And lastly, as can be seen in the chart below, historically there has been a very high correlation between unit labour cost* and CPI** ^{* unit labour cost = labour cost per unit of output, in other words, wages + productivity. ** CPI = Consumer Price Index (a measure of inflation)}

So, whether this is a coincidence or a feedback loop, where unit-labour-costs drive inflation, which drives unit-labour-costs, which drives inflation, which drives unit-labour-costs etc, I will leave that to the experts.

But it has to be a possibility, that higher wages lead to higher costs, which lead to higher prices, which leads to higher inflation.  

What’s more, it has to be a possibility that shareholders, many of whom are retired or saving for retirement, will also need higher profits if they are to afford: food, energy and healthcare, without imposing higher taxes on their children and grandchildren.

Why has productivity slumped?

I can think of three reasons, but I am sure there are more:

1. The ongoing rise of the service-economy.
   
   To illustrate, a farmer with a million dollar combine harvester can produce more (measured in dollars of output) than a single healthcare professional providing a one-on-one service. Both the farmer and the healthcare worker can be delivering their services in a highly productive and professional manner, they just require very different levels of capital.  
   
   So the decline in productivity, isn’t a reflection of poor work practice but rather a change in the mix of careers e.g. to support an aging population, and the gig economy.  
   
   In the last 20 years most of the jobs that have been created are in the services sector, as opposed to farming, mining, construction and manufacturing. ‘Household services’ (i.e., services to households) include healthcare, education and hospitality. ‘Business services’ (i.e., services to businesses) include the professional, scientific and technical services.
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2. I don’t actually have a chart for this, but I am certain, over the last two decades, there has been an exponential increase in legislation, litigation and bureaucracy. As a consequence, the farmer and the healthcare worker are spending more time recording what was done, how it was done, why it was done as opposed to actually getting it done.
   
   Again I am not disputing the need for appropriate record keeping, only making the observation that it has an impact on productivity. and;
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3. It is also worth noting the record low levels of youth unemployment, which is absolutely a good thing. I remember graduating from university with two degrees and youth unemployment being around 20%, no fun, but as we all know, when you enter the work force, there is still a lot to learn, and no doubt this is harder if your colleagues are working from home.
   
   It is also worth noting, that the lowest skilled workers have been receiving the biggest pay rises, perhaps in the response to the labour shortage, which is obviously a drag on the calculation of ‘productivity’.
   
   But hopefully both these trends are transitory and as the new recruits gain experience, confidence and independence, overall productivity will improve, taking the pressure off inflation.

So where to from here? Arguably a large part of the Covid supply shock has dissipated, as has the commodity price spike caused by the Russian sanctions. That being said, there are still some areas like international migration and return to work (as opposed to working from home), which are likely to take longer but in time will deliver productivity and continue to reduce inflation.  

Higher interest rates should also have an impact on the demand side. Slowing down new investment by businesses and households, so fewer jobs. But that being said, anyone with a loan, that has been able to achieve a 5%(+)p.a. pay-rise, over the last couple of years, could have potentially off-set the higher interest costs; particularly if they were already four to five years into their loan repayments. So demand from existing borrowers (although not all borrowers) has, so far, been reasonably well insulated by pay rises.  

But will this (i.e. additional productivity gains, less investment and higher interest rates) be enough to bring inflation back to the central banks’* target range of 2% to 3%? (*Currently, most central banks have the same challenge and a very similar target)

Well, honestly, not sure. It will be difficult for any country to go it alone, and still compete for skilled migrants. And very few, if any democracies have ever voted for higher taxes and lower spending, so the ‘tough’ medicine required to constrain demand is in short supply, certainly at the early stages of an inflationary spiral.  

So my best guess, at this stage, is that investors should be prepared for the possibility of a protracted period of elevated inflation (call that inflation of 4% to 5%) and higher central bank interest rates (call that 5% plus, i.e. around the current levels in the USA). That of course, is not the publicly stated plan but it has to be a possibility. If you would like to talk about your portfolio and your strategy, please call 07-3334 4856.

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Ken Howard is a Private Client Adviser at Morgans. Ken's passion is in supporting and educating clients so they can attain and sustain financial independence.

If you have any questions about your financial plan or your share portfolio, your strategy, investments or would just like to catch up, please do not hesitate to give me a call on 07 3334 4856.

General Advice warning: This article is made without consideration of any specific client’s investment objectives, financial situation or needs. It is recommended that any persons who wish to act upon this report consult with their investment adviser before doing so. Morgans does not accept any liability for the results of any actions taken or not taken on the basis of information in this report, or for any negligent misstatements, errors or omissions.